Real World Economics: Water tax could save California from its drought

It is hot and dry in California. Water is scarce and is likely to get scarcer over the next months unless there is substantial precipitation. With an eighth of our nation's population and an enormous agricultural sector, severe water shortages in the state can affect the U.S. economy as a whole. So, unless it rains, California's response to this challenge will impact many, not just the state's residents or natural-resource economists.

Gov. Jerry Brown recently proclaimed a "drought state of emergency," freeing up administrative restrictions that might hamper developing additional water supplies or transferring existing ones. He also called for voluntary 20 percent reductions in water use, noting that mandatory conservation measures could be introduced if the situation worsens and voluntary stinting is not sufficient. Local units of government can impose limits as they need. Bans on lawn watering or car washing with anything other than a bucket are being bruited about.

There is nothing wrong with all of this, but economists across the political spectrum would restate the obvious for Brown and other California policymakers: If the quantity supplied at a given price is not as great as the quantity demanded at that price, then the price is too low to be economically efficient; and if you have the specific objective of reducing the quantity used of something, the most economically efficient measure is to raise the price.

Finally, if producing or consuming some good imposes costs on others not involved either in the production or consumption activities, then society can be made better off and resources used more efficiently by imposing a tax on the good in question.

Advertisement

This tax should be calibrated so that the cost of the good to purchasers, including the tax, is equal to the marginal cost to society of producing one more unit, including externalities.

Anyone who has had introductory econ knows that none of this is controversial among economists. It is straight out of any standard freshman microeconomics text, whether its author is a Republican or Democrat, liberal or conservative. Of course, there are some politicians who are willing to sacrifice our nation's economic productivity on the altar of anti-tax demagoguery. But dealing with California's drought is an issue on which economists would present a united front.

There have been some increases in sundry water rates in California in recent months, and this is good. But I doubt that Brown or California lawmakers will pay much attention to any phalanx of intellectually united economists. Don't expect higher prices to be used as the primary tool for responding to this drought, or even as an important secondary one.

Instead, expect state or local government-imposed command and control regulations such as bans on lawn watering and car washing. Expect to see the usual TV news stories that some eatery has stopped giving out glasses of water to customers. This is a battle economists lose again and again.

So why do economists continue to agree on the importance raising price via a tax? Why is it still prescribed in all the textbooks? Why not rules restricting specific water uses?

The answer is the same one made against central planning in general. No one, government employee or private manager, has enough information to decide how important myriad different resources and even more numerous goods and services are to society. Given a lack of information, it is impossible for some planner to make sound decisions for the economy as a whole about what to produce, or how, using which resources or to whom it should be sold. But a private market can do that quite well.

Looking narrowly at water use, no elected officials or functionaries can ever know the varying benefits to society of each of the thousands of different ways in which businesses or households use water. And the cost of policing restrictions on such use would be enormous.

So governments resort to limits on a handful of visible public uses, such as car washing and lawn watering. But households also could do all sorts of things behind closed doors, from shorter showers and fewer but larger loads of laundry, to peeling potatoes in a basin of water rather than under a running tap, to shutting the water off while brushing teeth. Command and control cannot affect these uses, but people would respond to higher prices. And when one moves from household uses of water to commercial ones, the alternatives multiply many times over.

Economists' consensus solution would be for the state to impose a tax on all sales of water to final users. Those with the naive belief that unfettered markets never fail would decry this government "interference." But California water never has traded in a pure free market. It is beset with subsidies, administratively set prices, arbitrary allocations between different uses, government exercise of eminent domain to take water for municipal use and the like. And use of water, whether from surface sources or aquifers, has many external costs. So you are not going to achieve an efficient outcome without some government action.

Expect a knee-jerk reaction from those who obsess about taxes. But a tax on water need not cause a net increase in revenue. The object of the tax is to raise the price of water relative to all other consumer goods or industrial inputs. Tax water and then rebate all the money raised on a per capita basis. Some households will come out ahead and some behind. But they all still will face a money incentive to use less water.

I don't expect this to happen in response to this drought. But California's population continues to rise. Use of groundwater continues to exceed natural recharge. Desalinization is still expensive. And independent of climate change, we could be entering a dryer climatic period. So the problem of water scarcity isn't going to go away, and neither will the broad consensus among economists on the best way to address it.